Why the bear market in bonds is getting long in the tooth

It hasn’t been an easy stretch for fixed income investors, but more than two years into the current bear market for bonds, the worst may soon be over.

Much, of course, depends on the future state of the economy. Decelerating economic growth, global trade tensions and disinflationary forces could force central banks to rethink their plans for further tightening. If so, this would support a relatively better environment for fixed income next year. 

More specifically, from a rates perspective, the correction of the past two years is likely closer to an end than a beginning and government yields aren’t expected to move materially higher in the near to mid-term. To that end, the U.S. Federal Reserve has taken a more pragmatic stance in recent weeks and may not maintain its steadfast pace of hikes if fears of an economic slowdown persist in the weeks ahead. The Bank of Canada will also likely slow its pace of rate hikes as it contemplates the impact of lower oil prices, while other central banks, including the European Union, could fall even further behind.

Source: Bloomberg LP, AGF Investments as of November 30, 2018.

As for credit, the recent repricing in the market has made it relatively more attractive heading into the new year and, with the worst of the tightening cycle now likely behind us, rising rates have largely been priced in. A return to the “goldilocks” period of modest economic growth is also a potential positive for credit as is the fact that yields, following their gradual rise, are near their more recent upper bounds. And while overly aggressive central bankers and further weakness in commodity prices remain risks, the corporate sector continues to de-lever, resulting in healthier fundamentals compared to prior years. Any further repricing in the market should be an opportunity to acquire select oversold securities.

Emerging market (EM) bonds, meanwhile, faced a number of major challenges in 2018, but should regain momentum as some risks – most notably, a strong U.S. dollar – start to subside. While a swift and immediate turnaround is not expected, the growing divergence within EM will lead to opportunities for specific countries over others in the mid-to-long-term. At the same time, government issued debt is preferred to corporate issues, while both local and external market issues look more fairly valued.

All in all, investors can anticipate a greater divergence between winners and losers in this environment, which should bode well for those who take a more active approach in their portfolio.